Monday, October 15, 2012

Lesson #124: Vesting of Founder's Stock

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Founders of a startup are frequently surprised when venture
capital firms or other investors ask for vesting provisions to be placed on the
founders’ stock.The investors are
seeking to provide sufficient incentive for each founder to work through the
company’s critical early formation and development phase.If a founder leaves the startup early in the
process, it would be unfair to the other founders and the investors for the departing
founder to receive a “free ride” on the continuing efforts of the other
founders.The vesting terms cause a
forfeiture of the unvested shares, or a repurchase at a low cost, upon
termination of employment, thereby eliminating the free ride.

A typical vesting structure is a period of four years beginning
either upon the formation of the company or the closing of the first round of
outside financing, with a one-year cliff, meaning that 1/4th of the
stock vests on the first anniversary.Thereafter, the stock vests ratably with 1/48th of the stock
vesting each month. In some cases, the
stock instead vests annually with 1/4th of the stock vesting on each
anniversary.In either case, the founder
is 100% vested on the fourth anniversary.

The logic of this typical structure is that it takes a full
year to get through the formative stage, and thereafter, the value of the
company increases incrementally.The
typical vesting schedule tracks this common growth pattern, rewarding the
founder proportionately for services during these stages.

But, startups come in many shapes and sizes, and founders
can request and obtain variations from the four-year vesting schedule in
appropriate circumstances.Following are
a few of the most common reasons to adjust the vesting schedule:

1.Other Contributions
- If a founder has contributed money, intellectual property, or other assets to
the company, the stock issued in return for those contributions should be fully
vested, because the value has been provided in full and is not contingent on
the future services.Any remaining stock
issued for services would still be subject to vesting.

2.Prior Service
– If the VC investment is being made after the formation of the company, the
founders frequently are able to obtain credit for the prior services.For example, if the VC investment is made one
year after formation, the stock could be 25% vested upon closing the investment,
and the remaining stock would be subject to a three-year vesting schedule.

3.Shorter Startup
Period – If founders reasonably anticipate a shorter period to bring
products or services to market, profitability, or sale of the company, then
investors have a shorter risk period and the vesting schedule can be reduced
commensurately.

4.Track Record or
Expertise – If a founder has a proven track record or expertise that is
particularly needed for the company, that founder may be able to leverage this
strength into a shorter vesting schedule.But don’t overplay this hand – if the investor is convinced a founder is
critical, the investor may decide that vesting is even more important, to
protect against the damage to the company if this key founder leaves the
company.

Founders should always ask for the vesting of their stock to
accelerate upon (a) a sale of the company or (b) a termination of employment
without cause.This formulation for
vesting is called “single-trigger” acceleration, because the acceleration is
“triggered” upon the occurrence of either one of the two events.Investors usually want “double-trigger”
acceleration, in which acceleration only occurs if the founder’s employment is
terminated without cause following a sale of the company.Investors are concerned that single-trigger
acceleration will make the company more difficult to sell because, if all stock
vests upon sale, buyers will be unwilling to take the risk of founders leaving
the company shortly following the sale.

Finally, vesting stock creates a tax trap that first-time
founders do not expect.The tax code
treats the grant of stock to a company officer or employee as compensation for
services rendered.The founder is
required to recognize income equal to the value of the stock.When a company is initially formed, the stock
usually has no value, so the taxable income is $0.But, if vesting is placed on the stock, IRS
regulations deem the stock to be granted on the date of vesting.If the company’s value increases over time, as
anticipated, then the stock gains greater and greater value upon each vesting
date and the founder must recognize income on each vesting date.If the startup goes well, this income is
quite significant, resulting in substantial income tax at a time when the
founder may not have cash available to pay the tax.

Generally, founders can mitigate the above-referenced tax
costs by filing an election with the IRS, called an 83(b) election.The 83(b) election treats the stock, for tax
purposes, as if there is no vesting, thereby eliminating the taxable event upon
vesting.But, be careful with this issue
- the 83(b) election must be filed within 30 days of grant; no extensions are
permitted; the election applies only if the stock is issued in connection with
the performance of services; and the potential tax trap could be huge if you
fail to file in the 30-day period.Founders facing this situation should consult with knowledgeable tax
counsel to determine the availability and effects of an 83(b) election.

If you have any further questions from here, Jeff is happy to offer his further assistance. You can contact him at 312-360-6312 or jmattson@freebornpeters.com.

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